Letter of Intent: Representations, Warranties, and Indemnification

Well – the first business day of the year is officially over. Apparently Yahoo just rejected an offer from Microsoft for $80 billion because it wasn’t enough. My guess is that Microsoft forgot to include the “!” in Yahoo! and pissed someone off (the “!” has got to be worth at least $20 billion.) I felt like shit all day today, but my cold (the first one I’ve had this year) at least had a side effect of getting me out of a trip.

Regarding our Letter of Intent series, we are starting to get into the sticky stuff (if you need a visual, think of when you were a kid and you superglued your fingers together.) Every LOI will have some mention of representations and warranties (if you want to sound like you are in the know, you can call them “reps and warranties”, or just “reps”) being made by the seller in favor of the buyer. In our experience, the usual language of this paragraph is usually light in substance, but this section can have a profound effect on the deal and consume a ridiculous amount of legal time during the negotiation of the definitive agreement.

The first thing to note is “who” is making the reps. Does it say the selling company will be making the reps, or does it say the selling company and its shareholders are on the hook? Or – more typically – is it silent as to who exactly is stepping up to the plate? Given that many shareholders (from VCs to individuals who hold shares of the seller) are unwilling or unable to represent and warrant to the seller’s situation, try to get this spelled out in the LOI as most buyers will eventually accept that the company (and not the shareholders) is making the reps. Even though this is not something that you will want to have the lawyers fight over as they’ll spent hours exhausting all the theoretical arguments, this is usually how it plays out, at which point the business people have to get involved to get resolution on this (think superglue and fingers again.)

All LOIs also will have something regarding indemnification in the event that one of the reps or warranties is breached. Considering how important this provision is to a merger, it’s a wonder why so many term sheets say: “The Company shall make standards representations and warranties and provide standard indemnification to Acquirer.” To us, this is code for “we are really going to screw you on the indemnification terms, but don’t want to tell you at this stage so that you’ll sign the LOI and become ‘pregnant’ with the deal. Really – trust us – our deal guys and lawyers are nice and cuddly.”

Depending upon the situation of the seller (perhaps the seller is in a position whereby it wants to get the buyer ‘pregnant’ more than vise versa and is willing to take its chances with the lawyers arguing), we’d suggest that you at least sketch out what the indemnification will look like. Again, once the lawyers get involved, arguments like “it’s market and it’s non-negotiable” or “I get this on all of my deals” get bantered about and little good comes from it.

Oh – the buyer usually makes some reps also, but since they are paying for the seller, these are typically pretty light weight unless the buyer is paying in private company stock. If you are a seller and you are getting private stock from the buyer, a completely logical starting point is to make all the reps and warranties reciprocal. If you need a refresher on why, it’s analogous the to Unilateral or Serial Monogamy discussion that Tom Evslin and I had when the price of oil first hit $67 a barrel (or – if you just want a simple comeback when the buyer says “no way”, you can say “what is sauce for the goose is sauce for the gander.”)

You (Brad) said: “Even though this is not something that you will want to have the lawyers fight over as they

Lorne Groe

An old-timer once told me that over-working a LOI was like writing your wedding vows after the third date.

For me the purpose of a LOI is to make sure both parties have a good and written understanding of what we’ve agreed to so far, so we can move forward on an exclusive basis. I view the LOI as a business document with few legal points not the other way around. I go to great lengths to make sure the seller understands that based upon the results of diligence and the ever-changing world around us, the terms and condition may and probably will change. However, until I do my due diligence I can’t determine how strong my reps and indemnification need to be, do I need an escrow, how much for how long, etc. That’s why I keep the LOI short and simple, as sellers’ egos get bruised really easy. Better not to over promise.